Capital Gains Rollovers and the Two Sector Rental Housing Market: A Simulation Study of Toronto

Transcription

1 canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3, Capital Gains Rollovers and the Two Sector Rental Housing Market: A Simulation Study of Toronto Marion Steele* P r é c i s Dans les villes où le prix des maisons est en forte hausse, on a constaté depuis quelques décennies une réduction des projets de construction d immeubles locatifs à logements multiples en même temps qu une forte hausse des investissements dans les condominiums destinés à la location et les autres petits immeubles locatifs. Ce dernier type d investissement est très répandu : près de 8 pour cent des contribuables particuliers ayant un revenu cotisé à plus de $ a déclaré un revenu net de location ou une perte de location pour l année d imposition Les motivations différentes des investisseurs dans chacun des deux secteurs des immeubles à logements multiples et des condominiums correspondent à la double nature du rendement : les revenus de location et les gains en capital. Les données de l étude montrent que les gains en capital représentent le principal attrait des condominiums, une qualité qui n est pas sans rapport avec leur facilité de vente sur le marché soit des investisseurs ou des propriétaires occupants. On peut considérer que cette particularité vaut approximativement entre $ et $, soit la différence de prix d une unité d habitation type de deux chambres qui a été constatée entre le secteur des immeubles locatifs à logements multiples et celui des condominiums dans le marché de Toronto en Les simulations présentées dans l article montrent que la valeur actualisée nette des recettes d impôt pour le fisc que représente un immeuble résidentiel locatif à Toronto qui serait détenu sur une période de 20 ans est supérieure dans le marché des immeubles d habitation à logements multiples que dans le secteur des condominiums, lorsque les gains en capital sont modestes. En comparant des situations plus caractéristiques de chaque secteur de manière à présumer que les investissements dans le secteur des * Of the Department of Economics, University of Guelph, and Cities Centre, University of Toronto ( marionsteele@gmail.com). I am grateful to the editor, Alan Macnaughton, and two anonymous, thoughtful referees for comments, suggestions, and corrections that have greatly strengthened this article; to François Des Rosiers, Laval, for providing me with his nicely setup spreadsheets, the foundation of the spreadsheets used in this article; to Miana Plesca for her help with software; and to Mitchell Stein, Bev Dahlby, and other participants of the Deloitte Tax Policy Research Symposium for useful comments. I am also indebted to Vince Brescia, of the Federation of Rental-Housing Providers of Ontario for his insightful comments. The usual caveat that none of these people is responsible for errors of fact or interpretation is especially important here because my views and those of Vince Brescia differ in many respects. 460

2 capital gains rollovers and the two-sector rental housing market n 461 condominiums sont à court terme et que les gains en capital sont importants, les recettes d impôt provenant du secteur des condominiums restent inférieures, en raison d importantes pertes de location au cours de la période de détention. Si, contrairement à ce qu on pouvait s attendre, le prix des maisons devait diminuer d une façon importante, la perte de recettes fiscales enregistrée préalablement ne sera pas compensée par des recettes fiscales plus élevées à la vente de l unité d habitation. En cas de roulement de gains en capital, les simulations montrent que les recettes fiscales générées par les immeubles locatifs à logements multiples à Toronto demeureront importantes. Toutefois, dans le contexte d un enthousiasme irrationnel généralisé à l égard du secteur de l habitation, le marché des condominiums en location entraînera de lourdes pertes de recettes fiscales. L article traite des désavantages que présentent les petits immeubles locatifs pour les marchés des capitaux et de l habitation ainsi que pour les locataires. L auteur conclut que le roulement de gains en capital serait tout particulièrement problématique pour ce secteur locatif et il suggère d approfondir les possibilités offertes par une disposition relative à la capitalisation restreinte sur les immeubles locatifs. A b s t r a c t Over the last few decades, in cities with rapidly rising house prices, there has been little construction of multi-unit rental apartment buildings, while there has been major investment in rental condominiums and other small rental properties. This kind of investment is widespread: nearly 8 percent of individual tax filers with an assessed income exceeding $40,000 declared net rental income or a rental loss in the 2005 tax year. Investment motivation in both the multi-unit rental and condominium sectors reflects the two-faceted nature of return: rental income and capital gains. Evidence is adduced that capital gains are the dominant attraction of condominiums, a matter related to the ease of selling condominiums in either the investor or the homeowner market. This characteristic is estimated to account for approximately $36,000 to $73,000 of the difference between the price per unit of a typical resale two-bedroom apartment in the multi-unit rental and the condominium sectors in Toronto in Simulations in the article show that the net present value to government of the income tax revenue yielded by a rental residential property in Toronto that is held for 20 years is greater in the multi-unit than in the condominium sector, when there are modest capital gains. Comparing situations that are more typical of each sector by assuming that investments in the condominium sector are short-term and capital gains are large, the tax revenue from condominiums remains less, because of large rental losses during the holding period. If, contrary to expectations, housing prices fall, the earlier tax revenue loss will not be offset by large streams of revenue when the property is sold. If there is a capital gains rollover, the simulations show that the tax revenue generated by multi-unit rental properties in Toronto will remain substantial. However, under conditions of irrational exuberance in the housing market, rental condominiums will produce large tax revenue losses. The article discusses disadvantages of small rental properties for financial and housing markets and for tenants. It concludes that a capital gains rollover would be particularly problematic for this rental sector and suggests that a thin capitalization rule for rental property should be investigated. Keywords: capital gains n rollovers n investors n prices n housing n condominiums

3 462 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 C o n t e n t s Introduction 462 Two Sectors in the Rental Housing Market 463 Distinguishing Characteristics 464 The Income Tax System and Motivations for Investment in the Two Sectors 467 Leverage in the Two Sectors: The Tax Incentive and Constraints 468 Income Taxes Paid by Investments in the Multi-Unit Rental and Condominium Sectors 470 Modelling and Assumptions 470 Results for the Multi-Unit Rental Residential Sector 472 Results for the Rental Condominium Sector in a Rational Market 475 Results for the Rental Condominium Sector: Irrationally Exuberant Market 478 Returns and Taxes Paid If the Market Remains Irrationally Exuberant 478 Returns and Taxes Paid If the Period of Irrational Exuberance Is Limited 478 A Legal Impediment: An Income Gain Rather Than a Capital Gain? 480 The Effects of Tax Forgiveness on Return and Taxes Paid: Differential Effects on the Multi-Unit and Condominium Residential Sectors 480 Evidence of the Importance of Lock-In for Rental Residential Investment 481 Possible Implications of Highly Levered Investment in Small Rental Properties for Housing and Finance Markets 483 Conclusion 485 Appendix 486 Intro duc tion This article analyzes the consequences for the rental housing market of a capital gains rollover for reinvested proceeds. Such a tax change has been frequently proposed 1 as a remedy for the virtual absence of housing starts in the rental market that is, multi-unit residential buildings intended for rental occupancy. A rollover was proposed by the Conservative Party of Canada in 2006 and continues to be advocated by business groups. 2 Under this proposal, capital gains taxes would be eliminated for individual taxpayers if real estate or other assets are sold and the proceeds are reinvested within six months of the sale. The article argues that this rollover would greatly reduce the taxes paid by the small property rental sector, as well as increase an important distortion in the rental housing market. The distortion in the rental market results from the fact that the dominant source of new supply is non-traditional condominium units, duplexes, converted houses, and other small properties rather than traditional multi-unit buildings constructed for the purpose of rental. For years, the virtual absence of the latter 1 Ontario, Ministry of Municipal Affairs and Housing, Creating a Positive Climate for Rental Housing Development Through Tax and Mortgage Insurance Reforms, Second Report of the Housing Supply Working Group (Toronto: Ministry of Municipal Affairs and Housing, 2002). 2 Steven Chase, Harper s Capital Gain Promise Fades from View, Globe and Mail, February 11, 2008.

4 capital gains rollovers and the two-sector rental housing market n 463 source of new supply has been a cause of concern, 3 while only incidental attention has been paid to the former source. This article analyzes both sources. Under reasonable assumptions, in a high capital gains city, specifically Toronto, income taxes paid by investors in the two sectors are very different. They are higher in the multiunit than in the small property sector when the real estate market is irrationally exuberant and holding periods are short. This difference arises fundamentally because of the differing roles that capital gains are expected to play in the two sectors. The article continues with a discussion about the two-sector rental housing market its distinguishing characteristics, prices and rents, investment motivations, and leverage opportunities. Aggressive lending in recent years has made it easier to obtain the high leverage 4 that the tax system rewards, but that may harm the financial system. This sort of lending tends to be concentrated in rapidly inflating markets, where irrationally exuberant investments are motivated by expectations of high capital gains. To demonstrate the tax effects of the bifurcation of the rental sector, assumptions are set out for the simulation of operating results in the two sectors, for both short and long holding periods in a rational market. Assumptions are also set out for an irrationally exuberant market in the case of the small property sector. The discussion of results focuses on taxes paid during and at the end of the holding periods. Next, the simulation results of tax forgiveness on rollover are discussed. The article then moves to a larger arena: consideration is given to several implications for both the housing and the finance markets of exuberant investment in small properties, as well as the associated high leverage and aggressive lending. T wo Sec to r s in the Renta l Housing M a rk e t As noted in the introduction, the rental housing market has both a multi-unit allrental building sector and a small property sector. In the Toronto census metropolitan area, the first sector amounted to about 300,000 units in 2006, somewhat more than half of the total number of rental units: 584, In Canada as a whole, multi-unit rental is dominant in only a few areas. This situation is not unique to Canada: it is 3 Ontario, Ministry of Municipal Affairs and Housing, supra note 1. 4 Andrey Pavlov and Susan Wachter, Subprime Lending and House Price Volatility, University of Pennsylvania Law School Institute for Law and Economics Research Paper no (Philadelphia: University of Pennsylvania, 2008). 5 The first number is inferred from the fact that in the fall of 2006, Canada Mortgage and Housing Corporation (CMHC) identified for its rental unit universe 306,544 apartments in private rental buildings of three units or more. See Canada Mortgage and Housing Corporation, Rental Market Report: Toronto CMA (Ottawa: CMHC, 2006) (online: odpub/esub/64459/64459_2006_a01.pdf ). The second number represents total renting households (including non-private housing), from the 2006 census, Statistics Canada, 2006 Community Profiles Census Metropolitan Area/Census Agglomeration Toronto (CMA), catalogue number x

5 464 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 also true in the United States. 6 In Australia and the United Kingdom, there is little rental other than that involving small properties. 7 Distinguishing Characteristics There are two (linked) distinguishing characteristics of small properties. The first is tenure elasticity. Multi-unit rentals are more or less firmly fixed in the rental market, 8 while small properties are not so fixed; indeed, they frequently switch between rental and home ownership. 9 A rental condominium may be sold to an owner-occupier, or the reverse may occur. Similarly, a rental duplex may be sold to an owner-occupier who lives in one unit and continues to rent out the other one. The second crucial characteristic of small properties is that those who invest in them tend to pay more per unit than investors who buy units wholesale, regardless of whether they purchase apartment buildings or buy into real estate investment trusts (reits). The premium arises in part because of the absence of economies of scale in the transaction process, but it also stems from the dual market for small properties. An investor knows that when a unit is sold, the buyer may be either an investor or an owner-occupier. A rental condominium or other small property fetches the higher of the prices bid by these two differently motivated buyers. In contrast, the multi-unit investor has effectively no option but to sell to another investor. Prices and rents in these two markets reflect these characteristics. In the fall of 2006 in Toronto, the price of a two-bedroom apartment in an existing multi-unit rental building was typically under $100,000; for the purpose of calculations, I have set it at $90, This was less than half the price of a new multi-unit rental. 11 In 6 Amy S. Bogdon and David C. Ling, The Effects of Property, Owner, Location, and Tenant Characteristics on Multifamily Profitability (1998) vol. 9, no. 2 Journal of Housing Research Rayna M. Brown, Gregory Schwann, and Callum Scott, Personal Residential Real Estate Investment in Australia: Investor Characteristics and Investment Parameters (2008) vol. 36, no. 1 Real Estate Economics ; Kathleen Scanlon, with Christine Whitehead, The Profile and Intentions of Buy-To-Let Investors (London: The Council of Mortgage Lenders, 2005) (online: 8 In principle, a rental building may be converted into condominiums, an equity co-operative, or a co-share, but many municipalities put obstacles in the way, and in any case, transaction costs in conversions are steep enough to constitute a major barrier. 9 Marion Steele, Conversions, Condominiums and Capital Gains: The Transformation of the Ontario Rental Housing Market (1993) vol. 30, no. 1 Urban Studies ; Vince Brescia, Conversions and Demolitions Policies in Ontario: Myths and Realities (Toronto: Federation of Rental-Housing Providers of Ontario, 2005). 10 I was informed by an employee of a Canadian REIT in the fall of 2005 that the REIT would not pay more than $80,000 to $90,000 per unit in Toronto for a building; multi-unit buildings usually include a mixture of one- and two-bedroom units, as well as a few bachelor units. This value is consistent with other values that I found, mainly on Web sales sites, such as and example transactions posted on (The example posted August 19, 2008 was a Scarborough building, consisting mainly of two-bedroom apartments, listed at $73,421 per unit.) 11 The purchase price of a new apartment building, expressed in per-apartment terms, for an apartment that is 850 square feet, has two bedrooms, is of average quality, and has standard

6 capital gains rollovers and the two-sector rental housing market n 465 Toronto in April 2007, the median listing price for a two-bedroom condominium unit was $225, Thus, the median price of an existing small property was about $135,000 higher than the price of a unit in an existing apartment building. The difference between the price of existing multi-unit buildings and condominiums is the result of three factors: (1) the economies of scale when selling wholesale rather than retail, (2) the greater age of existing multi-unit buildings, and (3) the value of being able to buy and sell an individual unit. The calculation to determine the value of these three components is illustrated in table 1. To obtain an estimate of component (2), assume physical depreciation of 1 percent per year, a rate implicitly used in a well-known real estate textbook. 13 Assume a typical age of 30 years for an existing Toronto multi-unit rental building. The purchase price, new, of this property is estimated for 2006 at $204,000, with the value of land accounting for $47,000 of this amount. 14 Depreciating the building at a rate of 1 percent gives a property value at 30 years of age of about $163,000. For a comparison with the price of existing Toronto condominiums, assume the same depreciation rate, but an average age of only 10 years; this gives an estimated wholesale price for existing condominiums of about $189,000. The implication is that the difference in age accounts for $26,000 ($189,000 $163,000) of the difference in value between a condominium and a multi-unit rental. The markup of condominiums over wholesale because of a lack of economies of scale in marketing and other transactions costs is implied to account for about $36,000 ($225,000 $189,000) or 16 percent. This leaves the residual $73,000 ($163,000 $90,000) as an estimate of the value of factor (3), the ability of investors to own condominiums individually. 15 An alternative estimate of factor (3), obtained by comparing rents $1,067 for units in multi-unit buildings and $1,487 for condominiums is $36, Thus, I estimate that the value to investors of the ability to sell units individually in either features and amenities, is estimated at $204,000; the land value included in this amount is $47,000, using Ernst & Young numbers extrapolated to See Ernst & Young, Comparative Real Estate Finance Analysis (Ontario Ministry of Municipal Affairs and Housing, Housing Policy Branch, Housing Supply Working Group, 2001). For details, see Marion Steele, The Wholesale- Retail Rental Housing Split: Irrational Exuberance in Housing Markets and Effective Tax Treatment, August 2008, at 12 This was the median price in April 2007 of over 3,000 two-bedroom condominium units posted on the multiple listing service (MLS) site (online: located in the Greater Toronto Area. 13 Norman G. Miller and David M. Geltner, Commercial Real Estate Analysis and Investments (Upper Saddle River, NJ: Prentice-Hall, 2001). 14 Estimated using Ernst & Young numbers, supra note In other words, the market value of a 30-year-old building is far below the depreciated cost of a new building, as long as it is a multi-unit rental building rather than a condominium. 16 The rents are for two-bedroom apartments, from CMHC s Rental Survey, fall 2006, for conventional and condominium units: see Canada Mortgage and Housing Corporation, National Rental Vacancy Rate Inches Down to 2.6 Per Cent, News Release, December 14, For details of the estimate of $36,000, see Steele, supra note 11.

7 466 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 Table 1 Schematic Reconciliation of the Difference Between the Price Per Two-Bedroom Apartment for a Unit in a Multi-Unit Rental Building and in a Two-Bedroom Condominium Apartment, Toronto, 2006 Unit in multi-unit rental building Condominium unit Cost-based value, new building plus land (depreciation of building at rate of 1% of declining balance) $204,000 Market value, 10 years old (markup to cover marketing costs) $225,000 Cost-based value if 10 years old (depreciation of building at rate of 1% of declining balance) $189,000 Value at 10 years if sold wholesale but registered as a condominium (depreciation of building at of rate 1% of declining balance) $189,000 Cost-based value if 30 years old $163,000 Value at 30 years if sold wholesale but registered as a condominium ($73,000 discount for inability of investor to own an individual unit that can be sold in the owner-occupier market) $163,000 Market value $90,000 Market value at 30 years if sold as multi-unit rental instead of wholesale condominium $90,000 Note: These estimates of components should be taken as illustrative, giving only orders of magnitude. The basis for the estimates of the cost of new units and the breakdown into land and building costs is given in the text, as is the basis for the estimate of the market value of an average condominium unit and that of an average unit in a multi-unit rental building. The average ages assumed here are based on a crude estimate of the average age of the condominium stock and the multi-unit rental stock in Toronto.

8 capital gains rollovers and the two-sector rental housing market n 467 the renter or home owner market is in the range of $36,000 to $73,000. This estimate clarifies the reason why for many years there has been a virtual absence of construction of multi-unit rental in Toronto, demolitions of some older buildings, and pressure for conversion to condominiums. What do price-to-rent ratios tell us about the motivation of investors? The rents and prices provided above imply ratios of 7.0 and 12.6 respectively. 17 Following Capozza and Seguin, 18 these ratios reflect far higher expectations of capital gains in the condominium than in the multi-unit rental building market. 19 These expectations are grounded in the estimated annual real rate of house price increase of slightly more than 2 percent in Toronto over the 30 years ending in 2002, 20 and much higher rates over the last decade. The observed price-to-rent ratio for Toronto condominiums is not surprising if investors extrapolate from the past. The marked difference in expectations of capital gains between the two sectors of the rental market makes it important to examine the interaction between investment motivation and the income tax system. The Income Tax System and Motivations for Investment in the Two Sectors In real estate, as in the stock market, total return consists of two components: net (rental) income and capital gains. Rental income is taxed annually. However, capital gains are not taxed as they accrue, but when a property is sold, and only 50 percent of a capital gain is included in income. 21 The light taxation of capital gains relative to rental income strengthens the lure of the small property sector. The low price-torent ratio in the multi-unit sector indicates that lightly taxed capital gains are not an important lure there. Many multi-unit investors want a stable annual cash flow, and 17 The first price is $90,000 for a multi-unit rental; the second price is $225,000 for a condominium, and annual rents are respectively 12 $1,067 and 12 $1, Dennis R. Capozza and Paul J. Seguin, Expectations, Efficiency, and Euphoria in the Housing Market (1996) vol. 26, no. 3 Regional Science & Urban Economics The contrast may also be put in terms of the cap rate (the ratio of net operating income to price). Using the assumptions in table 3, this is 9.0 percent for the wholesale unit and 5.3 percent for the condominium unit. If the capital expenditure every five years were rolled into operating costs, the cap rates would be 8.2 percent and 4.4 percent respectively. If an adjustment were made for the fact that capital expenditure cannot be entirely written off in the year in which it is incurred, the cap rates would be slightly lower. 20 Canada Mortgage and Housing Corporation, Estimates of the Private and Societal Costs and Benefits of Homeownership in Selected Canadian Cities, Research Highlight, Socio-Economic Series no (Ottawa: CMHC, 2006). 21 A more generous treatment applies in the United States (see Miller and Geltner, supra note 13) and a less generous one (in some circumstances) applies in Australia, where total real capital gains are included in income. See Gavin A. Wood and Yong Tu, Are There Investor Clienteles in Rental Housing? (2004) vol. 32, no. 3 Real Estate Economics

9 468 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 many owners are reits, 22 whose units are frequently held by retirees. Furthermore, the trust structure does not allow unitholders to deduct losses, which tend to be associated, in the early years in which an investment is held, with properties that are expected to yield large capital gains. Theory predicts that it is investors with a high tax rate who will be particularly attracted to an investment with a dominant capital gains component. Wood and Tu 23 econometrically establish for Australia that individual investors in high tax brackets tend to be invested in properties, such as condominiums, with the high price-to-rent ratios that anticipate high capital gains. Leverage in the Two Sectors: The Tax Incentive and Constraints The Canadian tax system rewards leverage that is, a low equity-to-value ratio because interest expense is fully deductible, and a net rental loss produced by high debt is deductible against employment income. Such a loss is the likely consequence of high leverage combined with an expectation of high capital gains. It is only because of this expectation that the investor in a small property is willing to pay a price that is high in relation to the going rent. But the high price, together with a low down payment, implies that interest costs on a mortgage will be high and tend to create a net rental loss. There are a number of constraints on a strategy of high leverage, high tax-deductible rental losses, and high capital gains. The first such constraint is a legal one: investors are not permitted to deduct a loss created or increased by the capital cost allowance (cca) against their employment income. But there is no such prohibition if a loss arises because of high interest expense, 24 and these losses are valuable to taxpayers with high incomes from self-employment, for example. Indeed, there is a relatively high incidence of rental holdings among self-employed professionals: in the 2006 tax year, 10.2 percent of tax filers with professional income as a major source of income reported net rental income. 25 There is also no restriction on the deduction of 22 Boardwalk REIT, for example, reports that it owns nearly 37,000 units in Canada. See Boardwalk Real Estate Investment Trust, About Us-Boardwalk REIT (online: 23 Supra note This contrasts with the situation in the United States, where there is no special treatment of losses created by depreciation allowance; there is, however, a prohibition against deduction of any loss on rental properties a passive loss against employment income if the taxpayer has an income exceeding US$150,000, with the restriction phased in starting at US$100,000. In addition, the maximum deduction against employment income is $25,000 for those allowed to deduct any loss. Thus, the US treatment is more generous to taxpayers with employment income of under US$100,000, as long as the loss is not extremely large, and less generous to those with employment income over US$150, Calculated from Canada Revenue Agency, Final Statistics, 2008 edition (2006 tax year), interim table 3 (online: ). In a non-random survey, Arcturus Solutions found 39 percent of the landlords that it surveyed were

10 capital gains rollovers and the two-sector rental housing market n 469 a loss (including one created by the cca) against the net rental income from another property. Therefore, an individual accumulating property over time is apt to be able to deduct the net rental loss of recent purchases. Furthermore, recent court decisions have dealt a death blow to the previous requirement of a reasonable expectation of profit. 26 A second constraint is the economic one: higher leveraging adds to risk. There is a tradeoff between risk and return, and risk-averse investors generally do not make highly leveraged investments. But investors may assess risks unrealistically, especially in periods of rapidly rising property prices and irrational exuberance. The third constraint is institutional. Banks and other lenders may be unwilling to lend an investor as much as he or she wishes to borrow because of their assessment of excessive risk. Indeed De Meza and Southey 27 have shown that there is a theoretical case that entrepreneurs, including investors in real estate, tend to be irrationally optimistic. However, borrowers who purchase multi-unit rentals are reined in by the general use of guidelines, such as a minimum debt-coverage ratio (dcr: net operating income as a ratio of the mortgage payment) that borrowers must meet; a dcr of at least 1.20 is a common requirement. 28 In the case of investors in small properties, constraints are fundamentally different. Crucially, there was no need for a positive cash flow in July Canada Mortgage and Housing Corporation s (cmhc s) main private competitor, Genworth Financial, in July 2008 offered mortgage insurance for loans on small properties on terms that required little cash up front, with emphasis on the income of the borrower, not the property. High earnings could offset negative rental cash flow, 29 and this loan insurance was open to an investor with other rental properties. cmhc requirements were essentially the same, although some elements were less rigorous. 30 These criteria meant, for example, that a newly qualified surgeon living in rental accommodation self-employed, and it is possible that a few of these were professionals. See Arcturus Solutions, Individual Landlord Survey (Ottawa: CMHC, 2005) (online: pdf/64857.pdf ). 26 I am indebted to Professor Jinyan Li, of Osgoode Hall Law School, for this information (personal communication, summer 2007). 27 David De Meza and Clive Southey, The Borrower s Curse: Optimism, Finance and Entrepreneurship (1996) vol. 106, no. 435 Economic Journal For example, Canadian Mortgage Capital Corporation usually requires a ratio of See Canada Mortgage Capital Corporation, Multi-Residential Mortgages (online: 29 Genworth s qualification formula for investors in July 2008 was a generously amended version of that for home purchasers; the formula was provided in July 2008 on Genworth s Web site: (qualification requirements were more demanding in September 2009). Investors were required to have a credit score of 660 or better. 30 Canada Mortgage and Housing Corporation, Homeownership Products, July 2008 (online:

11 470 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 and having no savings could have obtained a variable-rate mortgage for investment in a few small properties. An alternative route for avoiding the dcr requirement is open to investors who own a home with substantial equity. An investor is able to borrow to buy an investment property with, in effect, a zero down payment. To do this, the investor establishes a personal line of credit (plc) secured by a mortgage on the home, unlocking noquestions-asked access to as much as several hundred thousand dollars. Qualifying for a large plc requires that potential interest payments be sufficiently low relative to the investor s personal income. The plc provides a route to financing 100 percent of the property value with debt. 31 There is evidence that households have been using the plc route. Table 2 shows that homeowners who own real estate besides their own home are far more likely to have a large plc debt than other homeowners of the same income level: 5.9 percent of homeowners holding real estate worth over $200,000 had plc debt over $100,000. Direct survey evidence on financing is not available for Canada, but a survey of uk owners of small rental properties found that remortgaging other rental properties and homes, as well as drawing on savings, provided the dominant source of down payment. 32 Income Ta x e s Pa id by In v e s tments in the Multi-Unit Renta l and Co nd ominium Sec to r s Modelling and Assumptions In this section, taxes and investment returns are estimated for both long and short holding periods for typical Toronto investments in the two rental housing sectors. It will become apparent that current tax treatment usually rewards rental condominiums relative to multi-unit rental. It especially rewards condominiums when investment is short-term and housing markets are irrationally exuberant. A capital gains rollover would exacerbate this problem. The rational assumption refers to expectations that are consistent with medium or long-run equilibrium in the models of Fallis and Smith 33 and Hendershott et al. 34 This assumption requires that all prices but the price of land rise at the same rate, 31 The same investor could join a partnership purchasing wholesale units and finance his or her portion of the down payment from a PLC. However, there are principal-agent problems in these partnership arrangements, which makes it appealing for individuals to own one or two units solely, rather than 50 or 100 units jointly with many partners. 32 Scanlon and Whitehead, supra note George Fallis and Lawrence B. Smith, Tax Reform and Residential Real Estate, in Jack Mintz and John Whalley, eds., The Economic Impacts of Tax Reform, Canadian Tax Paper no. 84 (Toronto: Canadian Tax Foundation, 1989), Patric H. Hendershott, James R. Follain, and David C. Ling, Effects on Real Estate, in Joseph A. Pechman, ed., Tax Reform and the U.S. Economy (Washington, DC: The Brookings Institution, 1987).

12 capital gains rollovers and the two-sector rental housing market n 471 Table 2 Incidence of Personal Line-of-Credit (PLC) Debt by Value of Other Real Estate Size of PLC Debt $50,000 to Over Value of other real estate $100,000 (%) $100,000 (%) $50,000 to $100, $100,000 to $199, $200,000 and over a a Means that 5.9 percent of families with other real estate worth $200,000 or more have over $100,000 PLC debt. Sample: families with major income earner age 25 to 64. Source: Estimates were computed from Statistics Canada s public use micro datafile, Survey of Financial Security, 1999 using its universal weights. so that the real price of buildings is constant, and real rents rise only if the real price of land does; this assumption about the price of buildings and rents is also used in Miller and Geltner. 35 Tax changes are not capitalized in the long run in these models because it is assumed that in the long run new buildings are elastically supplied at the construction price. The pre-2009 situation in Toronto and other inflating Canadian cities, described earlier in this article, in which new private-sector multiunit rental buildings are rare, is one of disequilibrium. Taxes paid and investment returns are calculated to reflect various investment situations during one holding period of 20 years and four successive holding periods of 5 years. Although 5 years may seem implausibly short for a holding period, Gau and Wang 36 found a mean of only 5 years far less time than their theoretical optimum for Vancouver apartment properties sold in the period between 1971 and Data from 2004 tax returns also suggest that holding periods were recently not much longer than this (see the discussion of table 8, below) Miller and Geltner, supra note George W. Gau and Ko Wang, The Tax-Induced Holding Periods of Real Estate Investors: Theory and Empirical Evidence (1994) vol. 8, no. 1 Journal of Real Estate Finance and Economics Furthermore, data for all residential sales most presumably to owner-occupiers sometimes indicate a surprisingly high number of very short holding periods. In Kitchener-Waterloo, Steele and Goy found that of 9,776 MLS sales in a 36-month period, 1,123 represented the sale of a property that sold twice during the period. Thus, under reasonable assumptions, a minimum of 6.0 percent of properties sold were held three years or less, and the mean length of holding periods for properties making up the 6 percent would be much less than three years. The data also included 35 transactions for properties that sold twice in the same quarter or more than twice in the three-year period. See Marion Steele and Richard Goy, Short Holds, the Distributions of First and Second Sales, and Bias in the Repeat Sales Price Index (1997) vol. 14, no. 1 The Journal of Real Estate Finance and Economics The data period included months of rapidly rising prices, the peak month of the price cycle, and some months of decline. It seems reasonable to conclude that a substantial percentage of very short holding periods were those of investors, especially investors in a position to incur minimal transactions cost.

13 472 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 The evidence reviewed earlier suggests that multi-unit investors are rational in the sense used here, while the typical small property investor is irrationally exuberant that is, expects the value of a small property to rise at a faster rate than its rent (for the assumptions used here, see table 3). This means that the price-to-rent ratio, which is 12.3 initially, and the cap rate, which is 5.3 percent initially, change dramatically over time. By the end of 5 years, they are respectively 15.3 (only a shade over the 14.6 ratio for small properties in Australia in 1997) 38 and 3.0 percent. These numbers mean that the investment makes sense only to investors who expect to sell in the owner-occupier market or to investors who in turn expect to sell in that market. For this reason, taxes and returns are estimated for the rational case in both sectors, while, in the irrational case, only condominiums are considered. It is assumed that an investor s only non-rental income is from employment and that investors are individuals (who may be members of a partnership) residing in Ontario and who are taxed at the top marginal rate of 46 percent. The analysis is conducted in nominal dollar terms, consistent with the nonindexation of the tax system. The rate of inflation and price increase for buildings in the rational set of simulations is assumed to be 2 percent, while the rate for land is 3 percent. The implied real 1 percent annual increase in the price of land is consistent with the fact that a building s location is fixed. Urban location theory predicts that when a city is growing, any given location within it becomes more valuable over time. 39 The assumptions for buildings and land together imply that the annual increase in the value of the property is between 2 and 3 percent, depending on the proportion of the initial value which is land. 40 Results for the Multi-Unit Rental Residential Sector Table 4 sets out summary data from simulations for the multi-unit investor. Under the current capital gains treatment, the internal rate of return, after tax, to the investor in a long-term investment is a handsome percent (panel a, column 1, row 1). However, the investment is highly leveraged: this return is based on initial equity of only 15 percent and such a low equity carries with it a palpable risk. A larger down payment in an investment of this nature would reduce leverage, reduce risk, and lower the rate of return. In the next two rows of table 4 are the net present values (npvs) to the government of taxes paid. These are discounted at the government of Canada s long-term 38 Calculated in Wood and Tu, table 2, supra note Denise DiPasquale and William C. Wheaton, Urban Economics and Real Estate Markets (Englewood Cliffs, NJ: Prentice Hall, 1996). 40 Physical depreciation of the building is assumed to be offset by capital expenditure every five years, costing 5 percent of the value of the building. This convenient assumption which allows at the same time (1) constancy in real terms of the price expected for new construction, (2) a positive rate of physical depreciation, and (3) rent changes that are not negative is taken from Miller and Geltner, supra note 13.

14 Table 3 capital gains rollovers and the two-sector rental housing market n 473 Assumptions Used in the Simulations 1. Multi-unit sector assumptions n Purchase price is $90,000 per two-bedroom unit (a building of 50 units is valued at $4.5 million). n Initial equity is 15%. n Mortgage loan, 85% of property value, is National Housing Act (NHA)-insured, with 40-year amortization. n NHA mortgage insurance fee, 5.25% of principal, is added to it (so gross mortgage loan is 90.25% of value). n Mortgage interest rate is 5.5%. n Rate of increase in the nominal value of the property is 2.25% per year. n Rate of increase in the nominal rent is 2.25% per year. n Initial rent per unit is $1,070 (approximate mean rent for conventional 2-bedroom apartment). a n Vacancy rate is 3.2% (rate for conventional Toronto apartments). b n Operating expenses are 35% of gross effective revenue (gross revenue minus vacancy allowance). n Land is 25% of total property value. 2. Small property sector assumptions n Purchase price is $220,000 for a condominium unit. n Initial equity is 5%. n Mortgage loan, 75% of property value, is not NHA-insured and has 25-year amortization. n Loan against PLC is 20% of property value; payments are for interest only. n Mortgage interest rate is 5.5%. n Interest rate on loan is 6.0%. n Rate of increase in the nominal value of the property is 2.15% per year in a rational market and 6.6% per year in an irrationally exuberant market. n Rate of increase in nominal rent is 2.15% per year in both a rational and an irrationally exuberant market; initial rent is $1,490 (approximate mean rent in fall 2006 c for condominium 2-bedroom apartment). n Vacancy rate is 0.5% (rate for Toronto rental condominiums). d n Operating expenses are 35% of gross effective revenue. n Land is 15% ($33,000) of total property value. a Canada Mortgage and Housing Corporation, National Rental Vacancy Rate Inches Down to 2.6 Per Cent, News Release, December 14, b Ibid. c Ibid. d Ibid. Source: NHA mortgage insurance rates for multi-unit rental are taken from Canada Mortgage and Housing Corporation, Reference Guide: CMHC Mortgage Loan Insurance for Multi-Unit Properties (5+ Units) (Ottawa: CMHC, 2009). bond rate in May 2007 just 4.25 percent. Income taxes paid over the 20-year holding period are a substantial $22,953, much higher than the $12,361 in taxes on capital gains and recapture of cca paid at the time of sale. The last four columns of table 4 show the results if the same property were held over 20 years by four different investors, the frequent-turnover case. The first investor purchases at the same time as the long-term investor, at the end of year 0; the second investor buys the property from the initial purchaser at the end of year 5.

15 474 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 Table 4 Investment Returns and Income Taxes Paid, Multi-Unit Rental Apartment Unit Frequent rollover: 5-year holding periods, year at end of which holding period starts 20-year Present value of values holding period in columns 3 to A. Under current treatment of capital gains: After-tax internal rate of return to investor (%) na NPV a to government of income tax: Before sale ($) ,953 14,053 3,815 4,450 5,174 5,998 Paid at sale ($) ,361 16,917 4,921 5,452 6,040 6,693 NPV to government of all income tax paid ($) ,314 30,971 8,736 9,901 11,214 12,691 B. With no capital gains tax on rollover: After-tax internal rate of return to investor (%) na NPV to government of all income tax paid ($) ,204 28,612 8,070 9,148 10,361 11,725 Note: Numbers may not add or subtract because of rounding. a NPV refers to the net present value. The NPVs shown in the last four columns are calculated as of the date when the holding period starts; for example, the NPV to the government of all tax paid for the holding period starting at the end of year 15 is $12,691; this is the NPV, as of the end of year 15, of taxes in years 16 to 20. The NPV of the four short holding periods shown in column 2 is the NPV, as of the end of year 0, of taxes paid during and at the end of all four holding periods. The discount rate used to compute the present value of taxes is assumed to be 4.25%, approximately the yield of government of Canada long-term bonds in April Details of assumptions used in the simulations are given in the text and table 3. An example of basic spreadsheets from which these numbers were derived is provided in table 9 in the appendix to this article.

16 capital gains rollovers and the two-sector rental housing market n 475 The price paid is that given by the base price, inflated according to the assumptions in table 3. Rents and operating expenses are the same in years 6 to 10 as they are in the long-term investment, but the mortgage payments and interest expenses are higher because the second investor makes a down payment of only 15 percent of the inflated price. The long-term investor has more equity than the short-term investor by the end of year 5 because of amortization and the increase in the value of the property. The cca taken is higher in the frequent-turnover case, in part because the cca clock starts anew with each investor. This as well as the higher interest expense and consequently lower net rental income before cca reduce the taxes paid during the periods that the investments are held, and these are less than the taxes paid at sales. The net present value of the amounts for the four successive holding periods is shown in the second column. 41 The present value of the taxes paid annually over 20 years is $14,053, much less than the taxes paid over the same years by the long-term investor. The present value of the taxes paid at sales by the four short-term investors, $16,917, however, is far greater than the taxes paid by the long-term investor. The government gains at this stage because of the frequent realization of capital gains and because CCA is recaptured every five years. 42 In conclusion, in the multi-unit case, short holding periods reduce government revenue. Taxes paid are approximately 10 percent less under four successive holding periods than under a single long holding period. 43 Results for the Rental Condominium Sector in a Rational Market The results are very different for the condominium investor. The high price-to-rent ratio $220,000 to $17,880, or 12.3 percent at the start of the investment virtually ensures that this will be the case. As can be seen from table 5, with a long holding period only $4,312 in taxes is paid during the operating years (panel a, column 1, row 2). Successive short-term investors pay no taxes whatsoever during their operating years (panel a, columns 3 to 6, row 2), and indeed the first in the sequence receives a $19 deduction. Much bigger deductions would be possible if the investors already owned rental real estate, provided that it was profit-making, because the investors could then deduct the full CCA. 41 This is the present value as of the end of year 0, which puts column 2 on a basis comparable to column 1. The present values in columns 3 to 6 are as of the end of years 0, 5, 10, and 15 respectively. 42 If the government discount rate were higher than the assumed 4.25 percent, as would have been appropriately assumed in the past, the difference between the net present value (NPV) of taxes paid at sale by long- and short-term investors would be even greater. 43 The NPV of the investment to the long-term investor is several times greater than the total NPV for the four short-term investors: $14,290 as compared with $1,441 (not shown in the table) if the after-tax discount rate of investors is 9 percent; an offsetting factor is that longterm investors have more equity tied up in the property.

17 476 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3 Table 5 Investment Returns and Income Tax Paid, Rental Condominium Apartment in Rational Market Frequent rollover: 5-year holding periods, year at end of which holding period starts 20-year Present value of values holding period in columns 3 to A. Under current treatment of capital gains: After-tax internal rate of return to investor (%) na NPV a to government of income tax: Before sale ($) , Paid at sale ($) ,118 10,920 3,040 3,474 3,979 4,545 NPV to government of all income tax paid ($) ,431 10,901 3,021 3,474 3,979 4,545 B. With no capital gains tax on rollover: After-tax internal rate of return to investor (%) na NPV to government of all income tax paid ($) ,041 5,935 1,603 1,882 2,191 2,535 Note: Numbers may not add or subtract because of rounding. a NPV refers to net present value. The NPVs shown in the last four columns are calculated as of the date when the holding period starts; for example, the NPV to the government of all tax paid for the holding period starting at the end of year 15 is $4,545; this is the NPV, as of the end of year 15, of taxes in years 16 to 20. The NPV of the four short holding periods shown in column 2 is the NPV, as of the end of year 0, of taxes paid during and at the end of all four holding periods. An example of basic spreadsheets from which these numbers were derived is provided in table 10 in the appendix to this article.